Wednesday, December 30, 2009

Is the Fed Monetizing the Debt?

Some of us have been surprised at how low the yields on Treasury debt continue to remain, despite the government's explicit and implicit promises of future deficits. Given all the shenanigans, I have suspected that somehow the Federal Reserve has been buying much more of the Treasury's bonds than we are being told.

In this context I read with great interest a recent analysis from Zerohedge [.pdf] that claims the government's own figures show that huge amounts of new Treasury debt has fallen into an accounting black hole:

So who really picked up the tab? To our surprise, the only group to actually substantially increase their purchases in 2009 is defined in the Federal Reserve Flow of Funds Report as the "Household Sector". This category of buyers bought $15 billion worth of treasuries in 2008, but by Q3 2009 had purchased a whopping $528.7 billion worth. At the end of Q3 this Household Sector category now owns more treasuries than the Federal Reserve itself.

So to summarize, the majority buyers of Treasury securities in 2009 were:1. Foreign and International buyers who purchased $697.5 billion.2. The Federal Reserve who bought $286 billion.3. The Household Sector who bought $528 billion to Q3 – which puts them on track [to] purchase $704 billion for fiscal 2009.

These three buying groups represent the lion’s share of the $1.885 trillion of debt that was issued by the US in fiscal 2009.

We must admit that we were surprised to discover that "Households" had bought so many Treasuries in 2009. They bought 35 times more government debt than they did in 2008. Given the financial condition of the average household in 2009, this makes little sense to us. With unemployment and foreclosures skyrocketing, who could afford to increase treasury investments to such a large degree? For our more discerning readers, this enormous "Household" investment was made outside of Money Market Funds, Mutual Funds, ETF’s, Life Insurance Companies, Pension and Retirement funds and Closed-End Funds, which are all separate reporting categories.

So that's rather odd, right? But then you read this and start to get queasy:

This leaves a very important question - who makes up this Household Sector? Amazingly, we discovered that the Household Sector is actually just a catch-all category. It represents the buyers left over who can’t be slotted into the other group headings. For most categories of financial assets and liabilities, the values for the Household Sector are calculated as residuals. That is, amounts held or owed by the other sectors are subtracted from known totals, and the remainders are assumed to be the amounts held or owed by the Household Sector. To quote directly from the Flow of Funds Guide, "For example, the amounts of Treasury securities held by all other sectors, obtained from asset data reported by the companies or institutions themselves, are subtracted from total Treasury securities outstanding, obtained from the Monthly Treasury Statement of Receipts and Outlays of the United States Government and the balance is assigned to the household sector."...So to answer the question - who is the Household Sector? They are a PHANTOM. They don’t exist. They merely serve to balance the ledger in the Federal Reserve’s Flow of Funds report.

Now it's true--as Robert Wenzel says in his pooh-poohing of this report--that the terminology is inaccurate. For one thing, it's not really clear that this would be a Ponzi scheme, and for another, the Household sector obviously exists. Also, I had trouble following their argument, because they kept switching between fiscal and calendar years, and I wasn't sure that they themselves were keeping the distinction straight.

Even so, I think Wenzel is quibbling over the authors' use of headline grabbing vocabulary, when their underlying analysis (assuming it is accurate) is quite startling. It's true that we might expect households to load up on Treasurys because of the crisis, but wouldn't you expect them to do so through MMFs, Mutual Funds, ETFs, etc.?

Wenzel also says this: "In short, the Fed has been conducting business as usual, printing money, aka counterfeiting. It is highly unlikely they have attempted to cook the books when they have willingly reported the trillions in reserves they have otherwise pumped into the system. It makes no sense."

Of course Wenzel is right in the grand scheme of things, but I think he is being a bit too glib here. Even the average investor, who doesn't even know how a gold standard works and thinks money is supposed to be pieces of paper, understands the danger in the Fed "monetizing the debt." Up till now, the Fed officially says that its purchases of Treasury debt are only to achieve its goals of monetary policy.

But if the average investor starts to think that the Fed is buying more Treasury debt because Obama needs to run a bigger deficit, then the fat lady needs to warm up her voice. At that point, even the dullest of financial analysts will realize, "Wait a minute, they're just printing up new dollars to pay their bills! Prices will surely rise."

Last point: The Zerohedge report says that in 2Q 2009, the Fed (through its "quantitative easing") purchased 48% of the new Treasury debt issued! I hadn't realized it was so high.

Eh, maybe Wenzel is right: If worldwide investors can see what's right in front of their faces and not bat an eye, maybe the Fed has no reason to hide anything. Bernanke could say, "My parametric estimation leads me to conclude that a sustained yet modest recapitalization of my personal checking account by $1.8 million per week will be vital to achieving the Federal Reserve's dual mandate of vibrant economic growth and low price inflation."

There is a serious crisis in the making. In Fiscal 2010, Foreign and International are unlikely to increase their holdings, because capital inflows from a reducing trade deficit will be lower, and I think the 23% increase in this category of holdings reflects portfolio adjustments into less risky assets (remember most international investors account in USD). This portfolio shift will end some time, and possibly reverse in 2010.

It is very likely that the authorities "printed" $286 bn (Fed purchases), plus $529 bn (hidden in Households) totalling $815 bn, over half the $1,530 raised. If you think this is bad, think through this fiscal year, and understand why rates allong the yield curve are rising. Unless the Fed increases rates, the $ is toast.

We don't see it in stats like M2 money supply yet, but this is the start of a dose of monetary inflation that at some stage will prove impossible to retract from.

It is not entirely correct when you say the Fed bought 48% of Treasury debt issued. They bought Treasury securities equal to 48% of debt issued. This was most likley bought through the secondary market from primary dealers. If the PD's then put it the Funds on deposit with the Fed as excess reserves, it wouldn't have impacted M2 (and depending what else the Fed was doing, it could have been a money drain).

Further, if the Fed bought directly from the Tresury, this money would have much more likley entered the system, unless the Treasury just put it on deposit with the Fed. Unlikely , but remember, at one point in 2009 (possibly late 2008) the Fed did ask the Treasury to issue debt and just put it on deposit with the Fed, thus draining money from the system.

Keep in mind Bernanke is a mad scientist, nothing is as simple as it first appears if he is involved.

It is not entirely correct when you say the Fed bought 48% of Treasury debt issued. They bought Treasury securities equal to 48% of debt issued. This was most likley bought through the secondary market from primary dealers.

That sounds like you're saying, "It's not true that consumers bought 80% of the cars produced by Honda last year. The overwhelming majority bought their cars from dealerships."

I agree that Fed purchases won't show up in grocery store prices if the sellers of the bonds keep their reserves bottled up on deposit with the Fed. I just think that is postponing the reckoning, however.

And I totally agree that I do not know for sure what Bernanke is up to.

At the same time, "households" have been dumping GSE securities and the Fed has been snapping them up. So it seems that the Fed is indirectly monetizing even more (a lot more) debt than their Treasury purchases indicate. "Households" are just acting as middlemen (or money lauderers), like this:

1)Fed prints $ to buy GSE securities

2)"Households" sell GSE securities to the Fed

3)"Households" use newly printed $ to buy Treasuries

The end result is that the Fed ends up with a shed load of GSE's ($900 billion or 40% of it's balance sheet), 'households" load up on Treasuries, and Treasury gets a whole bunch of newly printed $.

The new debt effectively gets monetized, while the Fed can still plausibly deny that they are monetizing the debt.

My argument was that due to the runaway deficits being run by the government, there would be a lack of foreign confidence in the dollar and a relatively sudden collapse.

My friend was claiming that it was true the dollar would lose a lot of it's purchasing power, but that this would occur as a gradual strangulation over a long period of time. Is this a possibility/is there any precedent for this?